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Revenue Sharing: Uneven Impact and Uneven Payout?

A recent Wall Street Journal article addressed revenue sharing, dealing mostly with the important issue of the “uneven” impact that revenue sharing can have on DC investors’ fund expenses. There is, however, another side that needs to be explored as well: the uneven distribution of revenue sharing from the fund companies to the plan. To understand this issue more thoroughly, it’s helpful to consider why revenue sharing is paid and where it comes from.

Though different funds pay varying amounts of revenue to the plan, whether or not a fund pays revenue back to the plan should be rooted in a binary answer to a simple question: Does the fund have built into its internal expense structure fees that would otherwise go to pay for shareholder services?

If the answer is yes, then those monies ought to be paid to the plan. In fact, it could be argued that since the record keeping provider is essentially providing the shareholder services, if those monies for those services are retained by the fund provider, such a practice would run afoul of at least the spirit of ERISA. That is to say, no monies should be charged to the plan — directly or indirectly — for services not provided.

If the answer is no, then one has to assume that the fund is an institutional fund, which does not have an expense structure designed to provide shareholder services to retail clients and, therefore, should not be required to pay revenue sharing to a plan.

Of course, in the real world, how revenue sharing is paid to plans is all over the map. This requires the plan advisor to dig deeper and determine the nature of each individual fund’s expense structure, making every effort to ensure that the plan is receiving its deserved percentage of the fund internal expense charges. It is helpful to consider some of the nuances of different fund types and expense structures.

The WSJ article mentions the fact that actively managed funds generally pay more than index funds. While that statement is true, the reason for this discrepancy is not clear. It does not cost one penny more to provide shareholder services to an index fund investor than it does to an active fund investor.

However, it is the case that, in general, active funds pay out most, if not all, of their built-in shareholder expense while retail index fund providers are less inclined to do so. As an example, the retail cost of an S&P 500 index fund can range anywhere from 10 to 18 BPs, while the institutional cost of the same index should range from 3 to 5 BPs. Given that an S&P 500 index fund is close to being a commodity in the fund world, the difference between the expense of the retail and institutional fund, presumably, is the cost of shareholder expenses and should, therefore, be paid to the plan. However, how often is it the case that revenue sharing is paid on an S&P 500 index (net of 3 to 5 BPs) when offered through a DC plan?

Some funds have lower-cost shareholder services built into their funds and, thus, pay out less. This is reasonable, if verifiable. Some funds have varying share classes that pay out varying amounts of shareholder fees, which are directly reflected in the share classes (e.g., R-1 through R-6), which is reasonable as long as it all gets paid out.

Then there are funds sold primarily through advisors to individuals, which have custodial fees pay the fee for shareholder services, given the fact that the end investor is typically an individual investor. They should not be required to pay out shareholder services. However, the advisor should not compare the performance of these funds or any institutional funds with retail funds without making the appropriate expense/revenue sharing adjustments.

As the WSJ article attests, there is a need for significant reform in the way that revenue sharing is allocated to DC investors. In addition, it is also important for the advisor to have a detailed understanding of a fund’s expense structure for the purpose of negotiating all monies due to the plan as well as to understand the need to adjust the performance ranking net of any fees that are paid or not paid to the plan.

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